For at least the last four years market prognosticators have been warning investors about rising interest rates, which have been at historical lows since 2009. Rising rates are considered negative for both stock and fixed income investments, but especially for bonds since the value of existing bonds are generally worth less when prevailing interest rates rise. A leading market strategist warned in June 2010 that “the bond market is in a bubble, and it’s getting ready to burst” due to the expectation of rising rates. In the meantime, four years later, interest rates are actually lower, as shown in the chart below. For this article the “interest rate” refers to the 10-year U.S. Treasury bond, which is a benchmark rate often used to set other rates, such as for mortgages.10-Year US Treasury Bond Rate: Jan 2010 - Apr 2014

At the beginning of 2014 a monthly Bloomberg survey stated that 97% of economists polled expected the 10-year Treasury rate to rise within 6 months. Four months into this prediction, rates have declined from 3.02% at year-end 2013 to 2.65% at the end of April 2014 – a significant 12% drop. The Bloomberg survey for April had 100% of economists saying rates will rise in the next six months. The rationale for this prediction seems to be that rates are so historically low that they are “due” to rise. This was the same argument made in 2010. As one fixed income manager at a leading firm put it in reaction to the Bloomberg survey: “when the entire market thinks one thing is about to happen, the opposite outcome is often in store.”Why are rates so difficult to forecast? Because there are numerous unpredictable and complex factors that affect rates. The most reported factor today is the so called “quantitative easing” undertaken by the Federal Reserve whereby our central bank is buying government bonds on the open market. By bidding up these bonds the interest rate is held in check, with the theory that this will help stimulate economic growth. The Fed has begun to “taper” its bond purchases, but this hardly means rates will rise. After all, the tapering began at the end of 2013 and rates have dropped since then. Besides bond purchases, the Fed also sets the Federal Funds Rate, another benchmark rate. Fed Funds has remained close to 0% for several years and it is unknown when they will be raised; mid-2015 according to many analysts. The Fed recently abandoned its 6.5% unemployment target as an “outdated” signal for the required economic growth needed to justify raising rates. The current economic data is confusing – the economy grew only 0.1% annualized in Q1 2014, a poor result blamed on the weather. The April unemployment rate showed a significant drop to 6.3%, but the labor force participation rate also declined sharply (matching a low from 1978) rendering the headline number dubious. Another way to look at it: 288,000 jobs were added in April, but at the same time 806,000 Americans “dropped” out of the labor force and therefore are conveniently not counted as unemployed. Other factors that affect rates include worldwide economic strength, inflation (low inflation generally means lower interest rates, and right now inflation is low), purchases of Treasuries by foreign governments, general market demand for Treasuries (which remains robust), and global turmoil. When global turmoil is “high,” such as with the current Ukraine crisis, investors seek a safe haven in Treasuries, driving up their price and interest rates lower.The point of this article is not to offer a view on interest rates, but to reiterate one of our core investment themes: market predictions are impossible. Like stock market predictions, interest rate predictions are doomed to failure, as shown by the evidence over the past five years. DIA therefore continues to recommend fixed income investments as part of a portfolio allocation. Some investors are “waiting out” the bond market, expecting yields to rise soon with the idea of eventually purchasing these higher yielding bonds. Sitting on the sidelines has not worked for the last five years as rates have remained stubbornly low. Other experts question if there is any “upside” left in bonds. The nature of this question suggests that bonds are a trading play. DIA’s strategy is not to trade fixed income but to boringly earn interest and hold until maturity. Even though rates may continue to remain flat or down for more years, we do accept that interest rate risk is elevated simply because rates are low. There are several strategies that DIA employs to minimize this risk: (1) Avoid bonds that mature beyond 10 years, and preferably 8 years. Long term bonds lock you into an interest rate that may be unattractive many years out. If you currently own a bond fund, you may want to scan the holdings and note the maturity dates. If the fund holds many bonds maturing in the mid-2020s and 2030s, it is taking on high interest rate risk. Many municipal bond funds hold long dated bonds. (2) Focus on owning individual bonds rather than bond funds, and plan on holding these bonds to maturity. By holding individual bonds an investor benefits from a fixed maturity date and can ignore price fluctuations. A bond fund buys and sells bonds daily and offers no maturity date. (3) Avoid Treasury bonds. Few investors in our view need the ultra safety of Treasury bonds. The extremely low yields are not worth an investment. Higher yielding assets are less susceptible to interest rate risk. (4) Reinvest income earned into new fixed income assets. If interest rates rise, income earned can be redeployed in these new, potentially higher yielding assets. Compounded interest is a powerful force. (5) “Ladder” maturity dates, which means owning bonds with various maturity dates. After a few years of this strategy, an investor will always have bonds reaching maturity, which can then be rolled into new bonds at prevailing interest rates. (6) Invest in floating rate fixed income instruments, such as certain types of preferred stock and bank loans. Interest rates should be completely ignored as a factor for stock investments. Since stocks should only be part of a long term portfolio (at least 15-20 years), the movement of interest rates are of little importance. If you have any thoughts of refinancing your mortgage, do it now and lock in today’s still low long term rates -- take the largest mortgage you can comfortably afford.Note that this article was written to provide information and education, and is not intended to be considered investment advice, which can only be provided by DIA following a consultation and execution of an Investment Advisory Contract.

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